The Proposition that Beta Is All Required to Determine a Security Expected Return - Literature review Example

Beta is the measure of the systematic risk or the market risk that is borne by a portfolio or an asset according to the Capital Asset Pricing Model (CAPM) as conceived by Sharp (1964) and also attributed to Linter (1965) and Black (1972). The model aimed to quantify the value of return from an asset that was necessary to compensate for the actual amount of risk borne in the process of investing in that asset so that the investment remained a rational choice by developing an economic model that related the notions of risk and return in quantifiable forms. The objective was to facilitate comparative assessment of different stocks, bonds or securities as options for financial investment. This model till date remains one of the most, if not the most popular framework on the basis of which investment decisions are undertaken. The CAPM essentially proposes that to induce an investor to bear more risk the expected return has to be raised. The model starts off by distinguishing between two types of risks borne by a security – systematic and unsystematic risk. Systematic risk refers to the risk that is in built in the system or the market which can not be eliminated through diversification while that part of the total risk which is specific to the asset itself and thus can be diversified away is referred to as the unsystematic or specific risk. This systematic part of the total risk borne by the investor is measured by the coefficient Beta and the CAPM implies in essence, a positive relationship between the systematic risk borne by a security as measured by beta and the return expected from it. It is also postulated in the CAPM that given certain assumptions, Beta is the only variable explaining returns from securities and thus no other risk measurements should be significant in determining these returns (Morelli, 2007). Beta measures the relative volatility of a particular stock by relating the movements of its price to ovaerall price movements in the market. The CAPM relationship is stated as: Expected Return from security = Risk free rate of return + Beta (Expected Market rate of return – Risk Free rate of return)1 Evidently, if the value of Beta is given we can easily calculate the Expected return on a security given market data from this relationship. So, this proves the statement to be true. However, the CAPM has been one of the most debated of models and it is the relationship itself that has been questioned. A lot of empirical studies have found the relationship to be suspect while some actually have conferred to its postulates. Although initial tests of the CAPM2 yielded a significantly positive relationship between risk and return, subsequent adoption of the Fama and MacBeth (1973) methodology, which assumes realised values of returns to be proxies for the expected return values, in certain studies yield results which led to considerable doubts regarding the validity of the CAPM. For instance, an empirical examination of the American market by Fama and French (1992) did not find any relations between average returns from securities and the risk measured by Beta that could be termed significant. More interestingly their study revealed firm size and book-to-market equity to be significant explanations for the observed cross-sectional variations in the average returns of securities leading to the conclusion that these variables are significant measures of risk and this finding does appear to invalidate the notion of Beta being the only significant measure of risk as implied by the CAPM. In fact this proposition was previously refuted by Banz (1981) who showed that by including market equity as an explanatory variable the degree of explicability of the observed cross-sectional variation of average returns could be considerably raised thereby implying market equity to be a significant measure of risk3. A lot of studies that used the Fama and MacBeth (1973) methodology4, as mentioned earlier, proved the postulated relation to be insignificant leading to comments like “Beta as the sole variable explaining returns on stocks is dead” (Fama, New York times, February 18, 1992). However, it has been argued that in testing the relation the Fama and MacBeth (1973) methodology suffers from the drawback of using realised values as proxy for expected variables thereby first of all implying an implicit and significantly questionable assumption of people having very realistic expectations and secondly raising arguable doubts regarding whether it is actually the CAPM that is being tested (Morelli, 2007). Using realised values of returns as proxy for return expectations to test the CAPM is a method that can be accused of denying proper justice to the CAPM due to the fact that albeit expected market risk premium shall necessarily be positive the realised market risk premium may assume negative values. The essential focus of the CAPM is on the uncertainty of the individual investor regarding the sign of the market risk premium to be realised. Observe, if instead the realised return of the market always exceeded the risk-free rate, investors would have no incentive to hold the risk-free asset. Therefore the relationship between beta and expected returns differing from that between beta and realised returns should be expected when the realised value of excess market returns is negative (Pettengill, G., Sundaram, S., Mathur, I., 1995). Infact Pettengill et al (1995) infer during periods when realised excess market returns are negative, a negative relation between Beta and realised returns should be expected but since expected risk premium is never negative, this does not invalidate the finding of the CAPM. Adopting their own methodology that is free from this drawback5, Pettengill et al (1995) have shown that there exists a significant relationship in the US market between beta and security returns. In fact a lot of studies6 were conducted following the work of Pettengill et al that adopted their methodology and actually found validation for the CAPM in that Beta appeared to share a significantly positive relation with asset returns and moreover they found firm size to be insignificant as a contributor to risk. Although Morelli (2007), for UK data found no significant relationship between Beta and realised returns using the traditional methodology, using a slightly modified version of the Pettengill et al (1995) approach, beta is found to be a significant risk factor with a positive (negative) relationship with realised returns during up (down) markets. Moreover size is found to be insignificant though book-to-market equity is found to be a significant contributor. Therefore what emerges from this discussion is that albeit Beta in terms of significance and as indicator of the security returns is by no means “dead” as accused; rather adoption of the modern methodology in testing its significance reveals it to be very alive and kicking. However on a concluding note it has to be pointed out that Morelli’s study reveals book-to-market equity to also be a significant factor and this seems to be invalidating the provided statement in that Beta alone can not explain security returns at least for the UK market under certain conditions. References: Banz, R.W. (1981) The relationship between returns and market value of common stocks, Journal of Financial Economics 9, pp. 3–18. Black, F., (1972) Capital market equilibrium with restricted borrowing, Journal of Business 45, pp. 444–455. Black, F., M.C. Jensen and M. Scholes, (1972) The capital asset pricing model: some empirical tests. In: Jensen (Ed), Studies in the Theory of Capital Markets, Praeger, NY pp. 79–124. Chan, A., & Chui, A.P.L., (1996) An empirical re-examination of the cross-section of expected returns: UK Evidence, Journal of Business Finance and Accounting 23, pp. 1435–1452. Chan, K.C., & Chen, N., (1988) An unconditional asset pricing test and the role of firm size as an instrumental variable for risk, Journal of Finance 43, pp. 309–325. Chan, K.C., & Chen, N., (1991) Structural and return characteristics of small and large firms, Journal of Finance 46, pp. 1467–1484. Chan, L.K., Hamao, Y., & Lakonishok, J., (1991) Fundamental and stock returns in Japan, Journal of Finance 46, pp. 1739–1789. Davis, J., (1994)The cross-section of realised stock returns: the pre-compustat evidence, Journal of Finance 49, pp. 1579–1593. Elsas, R., El-Shaer, M. & Theissen, E., (2003) Beta and returns revisited: evidence from the German stock market, Journal of International Financial Markets Institutions and Money 13, pp. 1–18. Faff, R. (2001) A multivariate test of a dual beta CAPM: Australian evidence, The Financial Journal Review 36, pp. 157–174. Fama E., & French, E., (1992) The cross-section of expected stock returns, Journal of Finance 47 pp. 427–467. Fama, E., & French, K., (1995) Size and book-to-market factors in earnings and returns, Journal of Finance 50, pp. 131–155. Fama, E., & French, K., (1996) Multifactor explanations of asset pricing anomalies, Journal of Finance 51, pp. 55–84. Fama E. & MacBeth, J., (1973) Risk return and equilibrium: empirical tests, Journal of Political Economy 81, pp. 607–636. Fletcher, J. (1997) An examination of the cross-sectional relationship of beta and return: UK evidence, Journal of Economics and Business 49, pp. 211–221. Grinold, R., (1993) Is beta dead? , Financial Analyst Journal 49, pp. 28–34. Ho, R.Y.W., Strange R. & Piesse, J., (2000) CAPM anomalies and the pricing of equity: evidence from the Hong Kong market, Applied Economics 32, pp. 1629–1636. Hung., D.C.H., Shackleton M. and Xu, X., (2004) CAPM, higher co-moments and factor models of UK stock returns, Journal of Business Finance and Accounting 31 (1–2), pp. 87–112. Isakov, D., (1999), Is beta still alive? Conclusive evidence from the Swiss stock market, The European Journal of Finance 5, pp. 202–212. ] Lam, S.K., (2001) The conditional relation between beta and returns in the Hong Kong stock market, Applied Financial Economics 11, pp. 669–680. Levis, M., (1985)Are small firms big performers, Investment Analyst 76, pp. 21–26. Levis, M., & Liodakis, M., (2001) Contrarian strategies and investor expectations: the UK evidence, Financial Analyst Journal 57 (5), pp. 43–56. Lilti, J.J., & Montagner, R.L., (1998) Beta, size and return: a study on the French stock exchange, Applied Financial Economics 8, pp. 13–20. Lintner, J. (1965) The valuation of risky assets and the selection of risky investments in stock portfolios and capital budgets, Review of Economics and Statistics 47, pp. 13–37. Morelli, D. Beta, Size, Book-to-market value and Returns: A study based on UK Data., Journal of Multinational Financial Management, 2007 Pettengill, G. , Sundaram, S. & Mathur, I., (1995) The conditional relation between beta and returns, Journal of Financial and Quantitative Analysis 30, pp. 101–116. Sandoval E., & Saens, R., (2004) The conditional relationship between portfolio beta and return: evidence from Latin America, Cuadernos de Economia 41, pp. 65–89. Sharpe, W., (1964) Capital asset prices: a theory of market equilibrium under conditions of risk, Journal of Finance 19, pp. 425–442. Read More